Commentary

Refocus The Fed On Price Stability Instead Of Bailing Out Fiscal Policy

By John B. Taylor and Paul D. Ryan

The Federal Reserve's recent announcement that it will purchase $600 billion in Treasury securities has ignited a firestorm of criticism, opening a much-needed debate over the central bank's proper role in economic policy decisions. We share the concerns that many economists and policymakers have expressed about the Fed's decision to act.

The Fed's recent departures from rules-based monetary policy have increased economic instability and endangered the central bank's independence. It is time for common-sense reforms that refocus the Fed on sound monetary policy and remove it from contentious political debates over what policies are best to achieve other national goals.

Policymakers in Washington must recommit to laying the foundations for economic prosperity. Low and equitable taxes, reasonable and predictable regulations, restrained and responsible spending, and sound and honest money are the indispensable cornerstones of sustained economic growth and job creation.

By rejecting Washington's tax, spend and borrow agenda, American voters took a critical step this November toward returning these foundational principles to the center of our fiscal policy debates. But we must also realign our monetary policy if we are to achieve lasting prosperity.

Nearly a century ago, Congress established the Federal Reserve as an independent central bank with the power to control the supply of money and thereby achieve price stability. The administration of monetary policy was rightly quarantined away from legislative deliberations on tax and spending policies.

Yet in the 1970s, Congress endangered the Fed's independence by tasking it with a dual mission: that of promoting "maximum employment," in addition to maintaining "stable prices." This dual mandate placed the central bank in the middle of heated political debates over economic and fiscal issues.

The Fed's latest unconventional program — commonly called quantitative easing 2, or "QE2" — follows last year's unusual interventions (now known as "QE1"), in which the Fed bought not only large amounts of Treasury securities but also securities backed by private mortgages.

Quantitative easing is part of a recent Fed trend toward discretionary and away from rules-based monetary actions. The consequences of this trend are clear: The Fed's decision to hold interest rates too low for too long from 2002 to 2004 exacerbated the formation of the housing bubble. And while the Fed did help to arrest the ensuing panic in the fall of 2008, its subsequent interventions have done more long-run harm than good.

QE1 failed to strengthen the economy, which has remained in a high-unemployment, low-growth slump, and there is no convincing evidence that QE2 will help either. On the contrary, QE2 will create more economic uncertainty, stemming mainly from reasonable doubts over whether the Fed will know exactly when and how to contract its balance sheet after such an unprecedented expansion.